Note that since the after-tax savings are equivalent whether the asset is bought or leased, they could be excluded as a cash flow for this analysis.
This material is optional. Most students are happy to use the aftertax rate on secured debt and call it a day.
A lease payment is equivalent to the debt service on a secured bond issued by the lessee, and the discount rate should be approximately the same as the interest rate on such debt. This also explains why the WACC should not be used.
Obviously, this section can be skipped for those classes that are satisfied with analyzing leasing with the technique presented in previous sections.
9.1 Types of Leases• The Basics – A lease is a contractual agreement between a lessee and lessor. – The lessor owns the asset and for a fee allows the lessee to use the asset. 21-2
Buying versus Leasing Buy LeaseFirm U buys asset and uses asset; Lessor buys asset, Firm U leases it.financed by debt and equity. Manufacturer of asset Manufacturer of asset Firm U Lessor Lessee (Firm U) 1. Uses asset 1. Owns asset 1. Uses asset 1. Owns asset 2. Does not use asset 2. Does not own assetEquity shareholders Creditors Equity shareholdersz Creditors 21-3
Differences leasing and borrowing• Lease payments are fully tax-deductible, but only the interest portion of the loan.• The lessee does not own the asset and cannot depreciate it for tax purposes.• In the event of a default, the lessor cannot force bankruptcy.• The lessee does not obtain title to the asset at the end of the lease (absent some additional arrangement). 21-4
Operating Leases• Usually not fully amortized• Usually require the lessor to maintain and insure the asset• Lessee enjoys a cancellation option 21-5
Financial LeasesEssentially opposite of an operating lease. 1. Do not provide for maintenance or service by the lessor. 2. Financial leases are fully amortized. 3. The lessee usually has a right to renew the lease at expiry. 4. Generally, financial leases cannot be cancelled. 21-6
Sale and Lease-Back• A particular type of financial lease• Occurs when a company sells an asset it already owns to another firm and immediately leases it from them.• Two sets of cash flows occur: – The lessee receives cash today from the sale. – The lessee agrees to make periodic lease payments, thereby retaining the use of the asset. 21-7
Leveraged Leases• A leveraged lease is another type of financial lease.• A three-sided arrangement between the lessee, the lessor, and lenders: – The lessor owns the asset and for a fee allows the lessee to use the asset. – The lessor borrows to partially finance the asset. – The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee. 21-8
Leveraged LeasesLessor buys asset, Firm U leases it. Lessor borrows from lender to Manufacturer partially finance purchase of asset The lenders typically use a nonrecourse loan. This means that the lessor is not Lessor Lessee (Firm U) obligated to the lender in1. Owns asset 1. Uses asset case of a default by the2. Does not use asset 2. Does not own asset lessee. In the event of a default by the lessor, the lender has a first lien on the asset. Also, Equity the lease payments are shareholders Creditors made directly to the lender after a default. 21-9
Capital Lease• A lease must be capitalized if any one of the following is met: – The present value of the lease payments is at least 90 percent of the fair market value of the asset at the start of the lease. – The lease transfers ownership of the property to the lessee by the end of the term of the lease. – The lease term is 75 percent or more of the estimated economic life of the asset. – The lessee can buy the asset at a bargain price at expiry. 21-10
9.4 The Cash Flows of LeasingConsider a firm, ClumZee Movers, that wishes to acquire a delivery truck.The truck is expected to reduce costs by $4,500 per year.The truck costs $25,000 and has a useful life of 5 years.If the firm buys the truck, they will depreciate it straight-line to zero.They can lease it for 5 years from Tiger Leasing with an annual lease payment of $6,250. 21-11
The Cash Flows of Leasing • Cash Flows: Buy Year 0 Years 1-5 Cost of truck –$25,000 After-tax savings 4,500×(1-.34) = $2,970 Depreciation Tax Shield _ 5,000×(.34) = $1,700 –$25,000 $4,670• Cash Flows: Lease Year 0 Years 1-5Lease Payments –6,250×(1-.34) = –$4,125After-tax savings 4,500×(1-.34) = $2,970 –$1,155 21-12
The Cash Flows of LeasingCash Flows: Leasing Instead of Buying Year 0 Years 1-5 $25,000 –$1,155 – $4,670 = –$5,825 We could also view the cash flows as buying minus leasing, which would simply change the signs on the cash flows. The discount rate is the aftertax rate on the firm’s secured debt. 21-13
9.5 A Detour on Discounting and DebtCapacity with Corporate Taxes• Present Value of Riskless Cash Flows – In a world with corporate taxes, firms should discount riskless cash flows at the aftertax riskless rate of interest.• Optimal Debt Level and Riskless Cash Flows – In a world with corporate taxes, one determines the increase in the firm’s optimal debt level by discounting a future guaranteed aftertax inflow at the aftertax riskless interest rate. 21-14
9.6 NPV Analysis of the Lease-vs.-BuyDecision• A lease payment is like the debt service on a secured bond issued by the lessee.• In the real world, many companies discount both the depreciation tax shields and the lease payments at the aftertax interest rate on secured debt issued by the lessee. 21-15
NPV Analysis of the Lease-vs.-BuyDecision• There is a simple method for evaluating leases: discount all cash flows at the aftertax interest rate on secured debt issued by the lessee. Suppose that rate is 5 percent.NPV Leasing Instead of BuyingYear 0 Years 1-5$25,000 –$1,155 – $4,670 = – $5,825 CF0 $25,000 I 5 CF1 –$5,825 NPV –$219.20 F1 5 21-16
NPV Analysis of the Lease-vs.-BuyDecisionNPV Buying Instead of LeasingYear 0 Years 1-5– $25,000 $4,670 – $1,155 = $5,825CF0 –$25,000 I 5CF1 $5,825 NPV $219.20 F1 5 21-17
9.7 Debt Displacement and LeaseValuation• Considering the issues of debt displacement allows for a more intuitive understanding of the lease versus buy decision.• Leases displace debt—this is a hidden cost of leasing. If a firm leases, it will not use as much regular debt as it would otherwise. • The interest tax shield will be lost. 21-18
Debt Displacement and Lease Valuation• The debt displaced by leasing results in forgone interest tax shields on the debt that ClumZee movers did not take on when they leased instead of bought the truck.• Suppose ClumZee agrees to a lease payment of $6,250 before tax. This payment would support a loan of $25,219.20 (see the next slide).• In exchange for this, they get the use of a truck worth $25,000.• Clearly the NPV is a negative $219.20, which agrees with our earlier calculations. 21-19
Debt Displacement and Lease ValuationCalculate the increase in debt capacity by discountingthe difference between the cash flows of thepurchase and the cash flows of the lease using theaftertax interest rate. After-Tax Lease Payments –6,250×(1 –.34) = –$4,125 Forgone Depreciation Tax Shield –5,000×(.34) = –$1,700 –$5,825 N I/Yr PV PMT FV 5 5 $25,219.20 –$5,825 0 21-20
21.8 Does Leasing Ever Pay: The Base Case• In the above example, ClumZee Movers chose to buy, because the NPV of leasing was a negative $219.20• Note that this is the opposite of the NPV that Tiger Leasing would have:• Cash Flows: Tiger Leasing Year 0 Years 1–5Cost of truck –$25,000Depreciation Tax Shield 5,000×(.34) = $1,700Lease Payments 6,250×(1-.34) = $4,125 –$25,000 $5,825 CF0 –$25,000 I 5 CF1 $5,825 F1 5 NPV $219.20 21-21
9.9 Advantage and Disadvantage forLeasing• Advantage – Taxes may be reduced by leasing. – The lease contract may reduce certain types of uncertainty. – Transactions costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset.• Disadvantage – Accounting methods of accounting for leases vs. the financial cash flows. 21-22